Your Guide to Accounts Receivable Factoring

For cash-strapped businesses with late-paying customers, accounts receivable factoring can help them get paid without chasing down customers. It’s more accessible, gives businesses more control over their finances, and frees up resources spent on collections activities.

If you haven't explored AR factoring, you could be missing out on opportunities to grow and invest while your competitors turn unpaid invoices into immediate cash. This article will cover the following aspects of accounts receivable factoring:

• What is accounts receivable factoring?
• How do you calculate AR factoring?
• How much will an AR factoring company pay for an invoice?
• Benefits of accounts receivable factoring
• Reasons to use AR factoring

What is accounts receivable factoring?

In accounts receivable factoring, a company sells unpaid invoices, or accounts receivable, to a third-party financial company, known as a factor, at a discount for immediate cash. When you factor accounts receivable, your company gets immediate payment for outstanding invoices to improve cash flow.

Types of factoring

There are three types of factoring accounts receivable:

• Recourse factoring
• Non-recourse factoring
• Maturity factoring

1. Recourse factoring

Recourse factoring is the most common type of factoring for receivables accounting. In recourse factoring, the business selling invoices retains the risk of customer non-payment. If the customer doesn’t pay the invoice in full, the factor can force the seller to buy back the receivable or refund the advance payment.

2. Non-recourse factoring

In non-recourse factoring, the factoring company assumes the risk of customer non-payment. If the customer fails to pay in full, the factor absorbs the loss.

3. Maturity factoring

With maturity factoring, the factor advances payment on the invoice and collects payments from the seller as the invoice matures. This is the least common type of factoring and is typically reserved for long-term invoices and large contracts.

How AR factoring works

The process for factoring of receivables follows several steps:

1. Seller submits invoice to factoring company
2. Factoring company advances percentage (usually 80-90%) to seller
3. Factoring company segregates resources by holding the remaining percentage (10-20%) of the advance as security
4. Factoring company collects payment from customer
5. Factoring company clears remaining payment amount and completes final payment to seller

Once a selling organization submits its invoices, the factor will verify details and ensure the invoices qualify (more on that in a moment). In most transactions, the factoring company advances 80-95 % of the factored amount the day the invoice is submitted.

The factoring company then holds the remaining amount of the invoice, typically 8-10%, as a security deposit until the invoice is paid in full. Then the factoring company collects money from the customer over the next 30 to 90 days.

After receiving payment in full, the factoring company clears the remaining balance, typically 1-3%, to the selling company. The factoring company makes a profit by collecting on the full amount of the invoice. See our example below.

How to calculate AR factoring

To calculate the funds a business can receive through accounts receivable factoring, the factoring company typically follows a three-step process:

1. Determine eligible accounts receivable:The factoring company reviews the company’s outstanding invoices. Generally, only invoices that are less than 90 days old and are owed by creditworthy customers are eligible for factoring.
2. Calculate the advance rate: The percentage of eligible accounts receivable the business can receive upfront. Typically, the advance rate ranges from 80-90% depending on customer creditworthiness and invoice risk.
3. Subtract factoring fees: Factor fees include a discount fee and service fee. Fees are subtracted from the amount of the eligible accounts receivable. The discount fee is the cost of financing—a percentage of the total factored amount. The service fee is a flat fee for administrative services like invoicing and collections.

The formula for calculating accounts receivable factoring is:

• Funds received = eligible accounts receivable x advance rate - factoring fees

Let’s say a business has $100,000 in eligible accounts receivable and the advance rate is 80%. The business can receive an upfront payment of $80,000. With a 2% discount fee and a $500 service fee, the factoring fees would be $2,500. Therefore, the business would receive $77,500 in total, and the factoring company would make $22,500 in revenue.

How AR factoring companies pay for invoices

An AR factoring company assesses several factors to determine how much to pay for an invoice:

• Creditworthiness of the customer owing the invoice
• Age of invoice
• Industry and sector of the selling business
• Number of invoices for sale
• Overall transaction risk

How credit histories and interest rates influence AR factoring

When a factoring company decides how much to pay for an invoice, one of the first things they look at is the debtor’s (i.e., the customer who hasn’t paid) creditworthiness. If they have good credit histories, the factor will be willing to pay a higher rate.

The prevailing interest rate is the most critical element for factoring companies considering payment amounts. If interest rates are high, the factoring company will likely pay less for an invoice, as they need to factor in the cost of borrowing money to finance the purchase. Conversely, if interest rates are low, the factoring company may be willing to pay more for the invoice because borrowing costs are lower and they can make a higher profit margin.

Benefits of accounts receivable factoring

Most companies consider accounts receivable factoring an alternative option to traditional loans, but AR factoring provides considerable advantages:

• Improved customer service
• Easier loan process
• Immediate cash flow and capital growth

1. Improved customer service

Accounts receivable factoring can help companies provide better customer service by offering more flexible payment terms and reducing the time and effort required to collect customer payments.

With immediate access to cash flow, companies can offer more flexible options to customers by extending payment terms, offering discounts for early payments, and providing other incentives to enhance customer experience.

By outsourcing accounts receivable collections to a factoring company, businesses can reduce the time and resources spent chasing customers for overdue payments. In reducing the manual collections duties, AR teams are freed to perform more strategic and impactful work, like improving customer service, leveraging data insights, and offering better products.

2. Easier loan process

Accounts receivable factoring doesn’t require collateral or impact a business’s credit rating. Because traditional loans do make those a part of the process, a business with less ideal creditworthiness might desire to avoid a credit impact, or be unable to put down collateral to maintain cash flow.

AR factoring also enables companies to be in more control during the loan process compared to bank lending. Bank loans are often considered a high credit risk. And if the loan requires the company to submit collaterals and recurring payments, it will negatively impact cash flow.

3. Immediate cash flow and working capital

Revenue tied up in unpaid receivables can affect payroll and overhead costs, putting the company in a precarious position. Accounts receivable factoring can be invaluable during these times when companies need immediate cash flow without waiting for customers to pay invoices in full.

AR factoring doesn’t impact a business’ credit rating or loan interest rate. Providing immediate cash flow helps companies build a working capital reserve for future growth and take advantage of new business opportunities.

Pros and cons of factoring accounts receivable

Below is a table listing the pros and cons of factoring accounts receivable:

3 reasons to use AR factoring

Accounts receivable factoring can be useful in situations where a business needs to improve cash flow or obtain immediate funding.

1. Maintain off-season cash flow

Seasonal businesses with fluctuations in cash flow, such as holiday-related manufacturers or wholesale manufacturers, may need additional cash to cover operating expenses during off-seasons. Accounts receivable factoring can be a reliable source of funding to bridge the gap between slow and busy times of the year.

2. Facilitate business growth

Businesses looking to expand into a new location or launch a new product often need additional funding. Factoring accounts receivable can help growing businesses be more flexible and eliminate cash flow concerns.

3. Improve risk management

Manufacturing, wholesale distributors, commercial real estate, and finance companies can leverage AR factoring for better risk management by analyzing the creditworthiness of partners and customers to mitigate non-payment risk. By purchasing accounts receivable from businesses with strong credit ratings and reliable customers, finance companies can reduce exposure to bad debt.

Build an AR process that fosters cash flow

Cash flow issues often drive businesses to factor their accounts receivable. But the best way to avoid cash flow issues is to automate your accounts receivable process.

Automating accounts receivable for reliable cash flow

Automation can generate and deliver invoices on time, accept and process payments, match and apply payments to open invoices, and ensure financial reporting accuracy without manual intervention. AR automation software tools streamline the entire AR process and accelerate cash flow.

AR automation tools can automate the most tedious accounts receivable tasks, like printing invoices and stuffing envelopes. Choosing the right AR automation software is an important decision. The right tool is valuable beyond just its features and capabilities; it will actually strengthen customer experience and relationships.

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Businesses can transform their accounts receivable process and turn unpaid invoices into immediate cash through AR factoring.

No matter where your organization is on your AR journey, Versapay has the resources you need to understand your existing processes and future needs. Take a few minutes to complete an assessment for a tailored accounts receivable roadmap that benchmarks you against your peers, analyzes your AR processes, and provides tailored recommendations for AR success.